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Fed to hold its fire this week, wants clearer economic view

An eagle tops the U.S. Federal Reserve building's facade in Washington, July 31, 2013. REUTERS/Jonathan Ernst

By Alister Bull

WASHINGTON (Reuters) - Federal Reserve officials are unlikely to make any shift to monetary policy this week as they wait for more evidence of how badly Washington's budget battle has hurt the U.S. economy.

Indeed, they could stand pat for the rest of the year.

"I would say January or March at this point," said Scott Brown, chief economist at Raymond James in St. Petersburg, Florida, on when the Fed would begin to scale back its bond-buying stimulus. "Odds for December are less than 50/50."

Economic data released since a partial government shutdown ended has been surprisingly weak. Job growth slowed in September, a period that preceded the government's 16-daypartial shutdown, and business investment plans flagged.

Consumer and business confidence could suffer lasting harm after politicians flirted with a debt default by refusing to raise the U.S. borrowing limit until the last moment, in a deal that only postpones the fiscal fight until the new year.

Making matters worse, the shutdown interrupted data gathering in October, muddying the picture for Fed policymakers seeking signs on the economy's strength.

On top of the economic uncertainty, officials may be hesitant to make any dramatic policy shift given the upcoming leadership change at the central bank. President Barack Obama nominated Janet Yellen, the Fed's current vice chair, earlier this month to replace Ben Bernanke as Fed chairman when his term ends in January.

The pending change at the Fed's top dims prospects for any shift in the time-being in its so-called forward guidance on interest rates.

"It is hard to see any compelling reason to change either policy or even to make major changes to the statement," said Dean Maki, chief U.S. economist at Barclays in New York.

The central bank's policy-setting committee is to release a statement on its policy decision on Wednesday, at the end of its two-day meeting, at 2 p.m. (1800 GMT).

NO STRONG VIEWS

The Fed stunned markets in September when it opted against slowing its bond buying from the current monthly pace of $85 billion. It had announced in June that it expected to begin reducing the program before the end of the year with an eye toward shuttering it altogether by mid-2014.

Signs of economic softness since the September meeting have vindicated the Fed's caution, and economists now think officials will wait until next year to ensure a recovery is in full swing.

"The Fed likely doesn't have a strong view on when tapering will occur at this point. They'll want to see how the shutdown affects the fourth quarter, as well as a couple more payroll reports," said Maki, who has pushed his taper call to March from December.

To spur growth and hiring, the Fed has held overnight rates near zero since late 2008 and has also quadrupled its balance sheet to around $3.7 trillion through three massive rounds of bond buying in a further effort to keep borrowing costs low.

The Fed has promised not to raise rates until unemployment drops to at least 6.5 percent, provided inflation looks set to stay under 2.5 percent. The jobless rate stood at 7.2 percent in September.

These thresholds are supposed to stop borrowing costs from rising rapidly once the Fed begins reducing its bond purchases.

But they did not look to be working very well over the summer, when financial markets pulled forward expectations for the first rate hike into 2014 after Bernanke said the central bank could soon begin to trim its buying.

LIFT-OFF

Minutes of the Fed's September meeting showed officials had discussed strengthening the forward guidance, either by lowering the unemployment threshold, or promising not to raise rates if the inflation outlook was beneath a certain floor.

But the minutes also showed that officials debated whether revised guidance would be credible ahead of the looming transition at the Fed's helm, implicitly acknowledging that commitments made by Bernanke might not be seen as binding on his successor.

Since the September meeting, expectations for the first rate hike have been pushed to April 2015 at the earliest, which lessens any pressure policymakers may have felt to change the guidance.

Markets now price overnight rates in January 2016 at 0.685 percent, down from 0.895 percent a month ago. At the same time, mortgage rates have declined and yields on 10-year U.S. Treasuries are down to 2.5 percent from almost 3.0 percent in early September.

"The market is not strongly at odds with what Fed officials themselves are signaling for the path for rate hikes, so their need to do a change right now is not that strong," said Michael Hanson, senior economist with Bank of America Merrill Lynch.

Twelve of the 18 Fed officials at the September meeting believed the first rate hike shouldn't come until sometime in 2015.